How to assess and manage investment risk

How to assess and manage investment risk

If you do these tasks well you can achieve your financial goals easily

Risk is perhaps the most used term in investing. It is also perhaps the least understood even by professional practitioners of the discipline. Investment theory quantifies risk statistically by measures such as Sharpe Ratio, Standard Deviation and R-Squared. If you're shaking your head and searching for the back button, fear not because this is the last time we'll use these terms. Most of us struggled with mathematics even in school, so what we need is a more practical approach. The purpose of this article is to look at risk in the way it applies to us ordinary investors.

Let's begin by reminding ourselves that by investing, what we are really doing is ensuring we have enough money for a goal in the future. This goal may be a comfortable retirement, children's education or a big purchase. The risk to us, simply put, is that we will fail to achieve that goal. This may happen because of many different reasons. A practical approach, which we can all adopt, is to know what these reasons could be and what steps we can take to protect ourselves.

The first risk is not knowing what the risks are. Every investment, including the so-called safe ones like bank deposits, insurance and cash under the mattress carries risk of one kind or another. Hopefully by the end of this reading you will have a reasonable understanding to not go blindly into the world of investing.

The author is the COO of scripbox.com, a 'virtual' basket of four scientifically chosen mutual funds which seeks to leverage the power of technology and Internet to make mutual fund investing simple and convenient.

How to assess and manage investment risk

The second risk is that we underestimate the goal. This usually happens because we fail to take inflation into account. A lakhpati was a big deal in the 1960s when 50 rupees was a good salary (remember the black and white movies and the hero celebrating his first job?). Today it is not. So, you need to make sure that 40 years from now when you're watching a rerun of Vicky Donor, you don't wonder why you thought a crore was a big amount in 2013! Your goals will increase in value with time and you need to make that inflation adjustment.

Let's assume that we've estimated the goal correctly. We may still not be able to meet it because our corpus did not grow to that amount. This is the third risk.

To achieve a particular goal value, we have three contributing components:

How much you invest

How much net return that investment generates, and

How long you invest for

The three are related. For the same goal you can invest less if your expected return is higher, or if you are investing for longer. To take an example: If you want 115 rupees one year from now, you can do one of the following:

Invest 100 rupees in an investment that gives 15 per cent (Higher return)

Invest 105 rupees in an investment that gives 10 per cent (Higher amount)

Invest 100 rupees in an investment that gives 7 per cent for two years (Longer period).

Please keep in mind that this is only an example. We know you can't go back a year in time and make the investment. Which is also why this point is so important to understand.

How to assess and manage investment risk

We need to make the choice that is appropriate for us by striking the right balance between our goal, our ability to invest, choice of investment option and the time period. We need to remember that you cannot put 100 rupees under your mattress or into an investment generating 10 per cent and expect to get back 115 rupees. This is a mistake unknowingly made by investors who pick so-called "safer" investment options. Opting for lower return investments will mean that you will need to invest more or for longer. There is no other way.

In the next installment, I will cover a few more risks:

Of not getting the expected return

Of losing your money

Of not being able to save long enough

Please use the comments section below to tell us how you perceive and understand risk and if there's something I am missing out.